Which Are Better, Equal-Weighted or Cap-Weighted Index Funds?

Investors playing the odds tend to invest in passively managed index funds, growing their wealth patiently alongside the expanding U.S. and global economies. A passively managed fund is when investment securities are not chosen by…

Investors playing the odds tend to invest in passively managed index funds, growing their wealth patiently alongside the expanding U.S. and global economies.

A passively managed fund is when investment securities are not chosen by a portfolio manager, and are automatically selected to match an index or part of the market.

Until 15 years ago, capitalization-weighted index funds were the only way to invest with this passive approach.

A market capitalization index fund invests in the same stocks that are in an unmanaged index, such as the S&P 500, and owns a proportion related to the market capitalization or the number of shares multiplied by its price. So the best performing large stocks are owned in greater proportion than smaller- and medium-sized firms.

The Index Funds S&P 500 Equal Weight (ticker: INDEX) upended the index fund industry with this new way of investing in January 2003. The equal-weighted index fund apportions each stock in the portfolio equally. So behemoth Apple ( AAPL) and smaller Stericycle ( SRCL) are owned in the same proportion under an equal – weight index.

Equal-Weight Index Funds Support Small Companies

While both approaches give investors diversification, “a market-weighted approach will yield different returns than an equal-weighted approach because the underlying holdings are held in different proportions,” says Kirsty Peev, portfolio manager at Halpern Financial in northern Virginia.

Peev says, “Performance results aside, we don’t believe that either approach is inherently better or worse — they just work differently.”

Both types of funds have their advantages and disadvantages, experts say.

Shawn Johnson, former chairman of the investment committee at State Street Global Advisors, one of the largest index managers in the world, acknowledges the market-cap bias in indexes favors larger companies. The reason for this approach, he says, is that market cap acts as a proxy for liquidity, which makes it easier to trade larger companies’ stocks than smaller firms’ shares.

The liquidity concern is less important today, since most stocks in either index type are liquid, he says.

“Equal weighted simply removes the large-cap bias,” says Johnson, who is now the founder of Guidon Global, a Boston-based investment firm. “This generally results in a lower – weighted average market cap.”

Although there are periods when each style outperforms, analysts typically favor smaller, faster growing companies, than the bigger ones, favored in a market – weight index.

A downside to cap-weighted portfolios is that due to the excessive concentration in the largest companies, these types of index funds are riskier, says Vijay Vaidyanathan, CEO at Optimal Asset Management in California. “An advantage of equal weight index funds is that equal weight is a simple and quick way to get better diversification of rewarded risk and cut back on unrewarded risk,” Vaidyanathan says.

When investing in stocks, investors expect a higher return for riskier assets, Vaidyanathan says. With more of investors’ money deployed into fewer shares, market-cap weighted index funds are inherently riskier.

Market-Weighted Index Funds Can Have Drawbacks

Market-weighted index funds are overweighted in companies that are currently outperforming the market and more heavily concentrated in fewer sectors, investor experts say. This approach is great when the large companies are on a tear. But over the long term, there are significant disadvantages with market cap – weighted index funds.

The financial markets are cyclical as companies go in and out of favor, says Steven Jon Kaplan, CEO of New York-based True Contrarian Investments. Since the cap-weighted index buys more large caps, it leans towards trendier companies and invests less in the less popular firms, he says. Over the long term, this will cause it to underperform compared with a fund with the same shares in equal weight. That’s because at some point, overvalued companies will return to its fair value.

Investors can equate a market – weight index fund with the momentum investing strategy. This approach invests in stocks with increasing growth and leads to the reality that the market cap – weighted index’s top 10 holdings make up over 20 percent of the value of the fund. This is great when the winners continue to grow, but not so much when they crash. Consider the dot-com bubble in the late 1990s when the tech darlings became overvalued and subsequently fell back to earth.

In contrast, equal – weight indexes are value – based. A value-based investment approach favors undervalued stocks with the potential to rise in price and return to fair value. When shares in Company A grow and become more highly valued, a portion will be sold and deployed into the lower-priced Company B to maintain the equal weighting of all companies in the indexes. This will lead to more selling and potential tax consequences, yet performance data favor the equal weight model.

Research also supports the long-term outperformance of equal over market – cap indexes.

When comparing the SPDR S&P 500 ETF ( SPY), a market – cap index fund, with the Invesco S&P 500 Equal Weight ETF ( RSP) over the last 15 years, the equal – weight fund wins. Despite a higher expense ratio, the cumulative returns from December 2003 to October 2018 for RSP was 145.98 percent compared to 91.05 percent for SPY.

The bottom line in the equal versus market weight debate is that there are pros and cons to each approach. With greater diversification, and a value bent, the equal weight index outperforms over the long term. From Oct. 20 to Nov. 22, a period right before excess stock market volatility, the SPY lost 4 percent while the RSP lost only 0.9 percent. But the higher management expense ratio of equal – weight funds can eat into returns. For investors seeking to overweight the top-performing companies, the market-weighted index fund is a better bet.

Finally, in a bull market, when the largest companies are out performing the smaller firms, investors can expect a market – weight index to pull ahead.